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Expert's Corner: The Use of Gold in Portfolios

Improving performance by adding precious metals

In times of trouble, gold is the perennial hot topic. "Buy gold--it's the only safe asset," goes the cry. And, for the past decade, it has been. According to Bloomberg, gold was one of the best-performing domestic asset classes in the 2000s.

Of course, looking at just one decade can be misleading--especially when that decade was the second-worst ever for stocks. Yet studies have shown that, over time, gold can add measurably to portfolio performance. Here's how.

Diversification

As a real asset, with limited supply and different market dynamics, gold has historically had low correlations with most equity and debt indexes, making it a valid diversifier both theoretically and empirically. In a November 2007 paper available from the CFA Institute--"Can Precious Metals Make Your Portfolio Shine"--the authors demonstrated that inclusion of various forms of gold could increase portfolio return and reduce variance. In other papers, gold has been compared to the small-cap equity asset class, which, while volatile, can be an effective diversifier. Gold, therefore, can add value in the context of Modern Portfolio Theory. Interestingly, this value-add has almost always come in inflationary periods, which leads us to the next reasons to consider gold.

Economics and Psychology

Beyond portfolio diversification, there are sound economic reasons to invest part of a client's wealth in gold. First, gold seems to behave differently from other real assets; it is treated as a store of wealth, as an end in itself. Few other assets, for example, are held by central banks as stores of wealth. As such, gold really is different from paper currencies and, in effect, from other real assets, partially because people believe it is.

This leads to interesting consequences. Real assets, in general, act as inflation hedges. Because it is perceived as a store of value, gold can be an inflation hedge as well, and this is said to drive the performance of gold during periods of rising inflation expectations. In fact, the value of gold in real terms has supported its use as a store of value. According to the November 2009 Yellow Book from BNP Paribas, since the early 1980s, gold has generally kept its real value between $100 and $200 per ounce in 1975 dollars, while the nominal price has increased with inflation.

The recent expansion of the money supply has driven a rush to gold as a hedge against future inflation, even though current inflation has not picked up and the Fed has not yet started raising rates. This suggests two things: first, that the perception of gold as a store of value still holds, and second, that much of the current price run-up reflects anticipated rather than current conditions; thus, it may be subject to revision if expectations change. This is supported by the current price in 1975 dollars of just above $200 per ounce, at the upper end of the range since the mid-1980s.

Demand, given current economic conditions and real dollar pricing, is therefore historically high. What about supply? In one sense, as noted above, gold is special. In another, it is just another commodity, which can be mined and recycled. One of the bulwarks of gold as a store of value is its scarcity. Has supply risen to meet current demand? It has; again, per the Yellow Book, supply has exceeded demand for the past three years, but only due to central bank sales.

The fundamentals--price in real dollars and supply/demand--suggest that gold is not poised for significant appreciation and, therefore, that caution should be used in allocating to it. Other indicators, however, continue to support investing in gold. As noted, since the mid-1980s, gold has traded in a relatively narrow, constant dollar value range. In the early 1980s, though, it spiked to more than $400 per ounce in 1975 dollars, suggesting that, in the face of continued economic weakness, gold may still have a long way to go, price wise. As an inflation hedge, gold also continues to potentially add value, providing potential insurance against the "tail risk" of very high inflation or other disruptions in the financial system. In the event of an early 1980s-style environment, it could be the beneficiary of a flight to quality. Should the central banks cease selling, supply could drop below demand, lending further support to continued appreciation.

So the case for gold, while subject to pricing risks, is supported as a diversifier and as an insurance policy. This is consistent with the results of the studies quoted, where gold improved portfolio results over time.

Structuring the Portfolio

Once you've decided to allocate a portion of a client's portfolio to gold, there are two main considerations: the asset allocation decision and how to implement it. Ideas about what proportion of the portfolio to allocate to gold range widely--academic studies suggest anywhere from 2% to 25%. With no definitive analysis, my recommendation would be to make it part of the real assets or commodities allocation in the existing asset model.

The implementation decision depends on what the client wishes to accomplish with the gold position. Physical gold--in the form of bullion or jewelry--provides the ultimate protection against a financial system collapse; if the banks go away, you still have the gold! This provides inflation and tail risk protection, but it has storage and high transaction costs, is relatively illiquid, and is subject to loss. As such, it has its own set of risks that financial assets do not.

Financial claims on gold are a second option. Financial claims on gold don't have the illiquidity or loss risks of physical gold, but they also don't provide the same protection against a financial system collapse. They do provide diversification and protection against inflation, as well as direct exposure to the asset class.

A third option is financial claims on gold production in the form of shares of gold-producing companies. Company shares allow returns through profitable operations, as well as gold price appreciation, but they also add the risks associated with those operations. Any investment in "gold" must therefore be analyzed among these three classes, and the appropriate answer depends on the client's goals.

Of the three options, physical gold seems to be the riskiest and to have the most downside, so unless your client really expects the world to end, it's probably not a reasonable option for a large position. Of the remaining options, the research reviewed shows that exposure to company equities, rather than to gold itself, provided superior results. This is reasonable, in that these securities should provide operational income, as well as exposure to gold price changes.

Other general factors in the decision include varying cost structures and asset exposure levels, as well as issues specific to gold itself, such as bullion exposure, storage costs, and tax treatments. These issues must be understood and fully evaluated. Clearly, the decision and implementation are not as simple as they first appear.

In summary, despite current pricing concerns, there are good reasons to include exposure to gold in a client's portfolio, and there are a variety of ways to do so. And, over time, gold exposure can potentially lead to superior results.

[Investing in gold involves risk and may not be suitable for all investors. Past performance is no guarantee of future results.]

Brad McMillan is vice president, chief investment officer at Commonwealth Financial Network, member FINRA/SIPC, a registered investment adviser, in Waltham, Massachusetts. He can be reached at bmcmillan@commonwealth.com.